Global equity markets were driven by the deteriorating macro-economic environment of soaring energy prices, difficult credit conditions and slowing economic growth in the second quarter. As such, investors gravitated toward stocks in the energy and materials sectors, while other sectors where mostly flat or down, bifurcating global equity markets.

Investors fled the U.S. equity market in June. In fact, the S&P 500 index had its worst June performance, down -8.7%, since June of 1930 when it declined -16.5%. U.S. mid cap stocks finished -8.0% for the month, faring slightly better than larger cap S&P stocks due partly to a much smaller weight in financials. Overall, June finished off a disappointing second quarter for U.S. equity investors who endured continued volatility. However, there were areas of absolute gains -- specifically in smaller cap and growth-oriented issues. This relative strength reflects the negative impact of financial and consumer discretionary sectors on index returns. Also of note is that a sole focus on valuation, without some incorporation of growth, was heavily penalized within all capitalization ranges.

There was very significant performance differentiation across quality, and actually within the index. The S&P 500 index experienced a wide performance spread between stocks with the lowest and the highest R.O.E.’s -- over 1400 basis points. This illustrates investor flight to well managed and sustainable growing companies. Additionally, the performance of the highest quality stocks was driven in part by sector exposure differences. Within the S&P 500 index, the energy sector represents 14% of the index and was up nearly 17%, while the financial sector comprises 16% of the index and was down -18%. The majority of the higher quality or higher R.O.E. companies were found in energy related stocks, with lower R.O.E companies concentrated in the financial sector.

In the international markets, small cap value stocks were the weakest performers, declining        -4.4% for the second quarter as measured by the S&P/Citigroup World ex U.S. Extended Market Value Index. In comparison, large cap growth issues were the strongest on a relative basis, with the S&P/Citigroup World ex U.S. Primary Market Growth Index actually rising 1.5% -- a 600 basis point spread. Given the numerous and diverse markets comprised by these benchmarks, this is a significant departure from the normally muted international style returns. Though value generally wasn’t rewarded, companies that delivered good earnings-per-share news were strongly rewarded by the market in the second quarter, reflecting a more normal environment where investors pay for stocks that can deliver real growth in a slowing world economy.

Global inflation appears to be accelerating, as inflation in the Euro zone reached a new record high of 4.0% year-over-year in June. This caused the European Central Bank (ECB) to raise interest rates to 4.25%. However ECB’s President, Jean-Claude Trichet, was surprisingly dovish in his statements and actually indicated that there were downside risks to growth. Before these statements, the world seemed to have bifurcated into two camps, one led by the ECB, determined to control inflation through higher interest rates, and the other being Bank of England (BOE) and the U.S. Federal Reserve, which believe global growth will slow enough to resolve potential inflation problems. Though the ECB is still concerned about inflation and may raise rates if inflation continues to advance, their stance has now shifted toward no inflation bias. Thus, it appears that there will not be a rate hike at their next meeting in August. This should calm the market’s worries that the ECB was going to start raising rates aggressively, and actually moves ECB policy closer to the BOE and U.S. Federal Reserve approach.

Though we expect increased volatility to continue, a more harmonious policy among the world’s central banks should allow investors to focus on evaluating the performance of individual businesses, rather than reacting to macro economic fears.